Janet Yellen Now Faces One Of The Most Bizarre Problems The Fed Has Ever Seen

Falling oil prices may be good news for consumers who have seen
prices at the pump start falling and the prices of other goods
starting to drop as well, but it could prove a headache for
Federal Reserve Board Chair Janet Yellen.

That's because the US, which just posted an astonishing 5% gain
in GDP, is now flirting with deflation.

The Fed is thus facing a bizarre economic dilemma: It has runaway
growth and collapsing prices at the same time. The weapons
available to Yellen to fight deflation are flimsy. Normally, the
Fed would want to lower interest rates. But they are already at
zero — there is nowhere left to go. And, of course, house-on-fire
economic growth usually calls for higher interest rates, which
would only exacerbate the deflation side of the problem.

The Fed most recently faced this problem in the 1980s, when low
oil prices spurred runaway growth. The Fed took its eye off the
ball at the time, leading to nearly 5% inflation by 1990.

Both Brent and West Texas Intermediate (WTI) crude oil prices
have fallen by more than half since June as the US shale oil boom
increased the supply of the commodity and signs that
emerging-market growth is slowing weighed on demand. The rout was
also compounded by the
surprising decision by OPEC in November not to cut production
in response to falling prices.

As Jan Hatzius, chief economist at Goldman Sachs,
writes in a recent note: "It is not inconceivable that Fed officials
will hike even if core inflation ends up close to 1%, as long as
they are convinced that the weakness is entirely due to temporary
factors such as energy prices and oil. But the hurdle for how
convincing other data need to be in this case would increase
significantly."

That is, the Fed may put its 2% target aside if the Federal Open
Market Committee (FOMC) decides that prices are being depressed
by short-term factors that will eventually stabilize or reverse,
pushing inflation back toward target. The International Monetary
Fund forecasts 3.1% growth in the US over 2015, while the
country's unemployment rate was 5.8% in November, around the
level that many economists consider the "natural rate" below
which wage gains would be expected to start pushing up prices.

This would imply that labor-market indicators would become
critical to the FOMC's analysis of when to raise rates — and in
particular wage growth. As
Yellen put it in August last year, "since wage movements have
historically been sensitive to tightness in the labor market, the
recent behavior of both nominal and real wages point to weaker
labor market conditions than would be indicated by the current
unemployment rate."

That is, rate hikes may be put on hold until people start seeing
the benefits of growth in their take-home pay.
Moreover, with global
fears over the prospect of deflation gripping much of the
developed world, the FOMC body could find itself under pressure
to hold off rate hikes while inflation remains below
target.

But there are big risks to this
strategy. If the dip in inflation due to commodity-price falls
helps to mask the underlying strength of the US economy, once
they stop falling inflation could come surging back and be much
more difficult to control.

Below is a chart showing
Barclay's forecasts for headline inflation. As you can see, after
dipping into negative territory, Barclay's expects CPI to head
above 2% by the end of 2015.

If the FOMC holds off for too long and expectations of higher
inflation take hold, then it could be much more difficult for the
Fed to bring it back to target over the medium term.

Moreover, Yellen has also indicated that sluggish wage growth may
not prove a sufficient reason to hold rates down. Sluggish wage
growth could reflect "pent-up wage deflation" that could be
holding back the pace of gains, labor's share of income could be
structurally lower than it has been in the past (firms are
spending a larger proportion of their money on
e.g. dividends to shareholders and investment
than on employees than in the past), and people who are
unemployed finding it more difficult than expected to return to
the workforce.

If those warnings prove accurate, prices may start to rise before
wage growth picks up substantially, implying that the Fed may
need to increase rates earlier.

There have indeed been numerous predictions of runaway
inflation over the past few years, all of which have proved
painfully wide of the mark. Nevertheless, the balance of risks
has been shifting as the US continues to recover from the crisis
and close the remaining economic gap it left behind.

The Fed is charged with working out a safe exit strategy
from its emergency policies, which many credit with having
rescued the country from economic disaster. However, the collapse
in oil prices has served only to make this difficult job even
harder.